5 Reasons Why Wal-Mart Is Investing in Canada's 'Food Margins'

Pricing wars have taken over the retail market in Canada. Target's margins are declining rapidly and Big Lots is exiting the marketplace altogether, but Wal-Mart still sees opportunity in Canada's grocery business.

"I'm not stopping until I get food in every box in Canada," said Shelly Broader, according to recent article in The Globe and Mail. Broader is a former grocery executive and the current CEO of Wal-Mart's Canada division.

Ten years ago the only place to shop for groceries was the grocery store. Today, people can shop for food at retailers like Walgreen, Target(NYSE:TGT), CVS, and Wal-Mart(NYSE:WMT). You can purchase everything from fresh produce to frozen meats and maybe even sushi, depending on the retailer and market.

On Feb. 4, Wal-Mart announced that it would be investing close to $500 million in Canada. The expansion is to include 35 new super-centers with full supermarkets. $91 million will be used for distribution network projects to growfresh food capability in Canada .

So, why is Wal-Mart investing in food margins? I'll give you five reasons:

Food is a consumable; once it's consumed customers must come back for more. Bill Dreher, a retail analyst with Deutsche Bank, told the New York Times that people shop for food an average of 2.5 times a week compared to once a month for drug stores.

Same store sales are down in Canada, but grocery sales are up. On the third quarter earnings call, the CEO noted that while comparable sales decreased by 1.3% in Canada, the company "had strong comp sales in food and consumables."

Food products are resilient in difficult economic times. According to the US Bureau of Economic Analysis, food consumption went up during the Great Recession as families ate in more than out.

Food and consumables represented 43% of total Canada sales in the first three months of 2013, up from 41.7% in 2011deleted Wal-Mart. In the U.S., food represents roughly 55% of revenues so there's certainly room for growth in the Canadian market.

The "Great Value" private label is a great value. These products give Wal-Mart the ability to sell products cheaper and at a higher margin.

The effect of Canada's pricing warsCanada may seem like an odd choice for additional capital investment at this time, especially for greater penetration into the grocery market. The last two years have been marked by increased competition which has sparked a wave of price wars.

Kenneth Wong teaches marketing at Queen's University in Kingston, Ontario. "Every time a major U.S. retailer moves in, especially in the discount space, it sends shock waves through the system and we see Canadian retailers cutting prices in anticipation of a defensive move," said Wong, as quoted in a recent Bloomberg article; "With Wal-Mart protecting what they have and Target coming in you're going to see the major Canadian chains embark on an even more aggressive price war." It's called "investing in margins" and it's a temporary strategy for a long-term pay-off. The question is, how long can Canada's stores withstand this attack?

Loblaw is a supermarket based in Canada. It is a division of Loblaw Companies Limited(NASDAQOTH:LBLCF), Canada's largest food distributor. While revenue was up 2.3% to $7.64 billion in the fourth quarter, which was better than expected, net income fell 8.6%, down from $139 million last year to $127 million this year. There's only one reason for an increase in sales followed by a decrease in margins-heavy discounts.

Pricing wars were too much for Big Lots(NYSE:BIG) which announced plans to exit the Canadian market in the third quarter. After only two years in the market the company said, "... we have not been able to gain the necessary traction in the Canadian marketplace that had originally been anticipated." The cost of Big Lots' "investment in margin" is expected to be over $50 million.

Fiscal 2014 will be Target's first full year operating in Canada -- the company has a total of 124 stores. According to Target's third quarter 10Q, Canada has been showing signs of difficulty and margins have taken a hit from "efforts to clear excess inventory following lower than anticipated year-to-year sales and supply chain start-up challenges." Canadian operations diluted earnings by $0.29 in the third quarter and $0.40 a share in the fourth quarter. In the most recent earnings announcement Target had the following to say about Canadian operations:

Our initial sales and profits in Canada have not met our initial expectations. Improving our sales in Canada is contingent on our ability to deploy new marketing programs that positively differentiate us from other retailers in Canada, and achieve market acceptance by Canadian guests.

It may not be long before Target exits Canada as well, which is exactly what Wal-Mart wants.

So what?It's no secret that Wal-Mart is facing some headwinds with declining same store sales, reduced spending due to cuts in food stamps, and difficulty in Brazil, China. and Mexico. Canada may be able to provide some relief for the retailer, however. As the competition among discount retailers and grocery chains grows in Canada, prices are dropping and Wal-Mart stands to benefit from the fallout. The company's stated strategy is "investing in margin," and unlike Target it's the foundation of the company's business model.

Wal-Mart isn't worried about pricing wars, as it creates pricing wars. The company plays a waiting game like a vulture for companies like Loblaw to fall, then swoops in and takes market share. The ability to compete based on price is Wal-Mart's economic moat and food is the perfect "gateway" product to lure customers in the door.